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Institutional Development in Developing Countries in a Historical PerspectiveHa-Joon Chang

March 18, 2002

1. Introduction
The issue of institutional development, especially under the slogan of “good governance”, has recently come to occupy the centre stage of development policy debate. During the last decade or so, the international financial institutions (IFIs) have come to recognise the limitations of their earlier emphasis on “getting the prices right” and have accepted the importance of the institutional structure that underpins the price system. Increasingly, the IFIs and many donor governments are putting emphasis on “getting the institutions right” and attaching “governance-related conditionalities”.

Critics argue that the institutions of developed countries can be too demanding for developing countries in terms of financial and human resource requirements. They have an important point to make, but in the absence of some idea as to which institutions are necessary and/or viable under what conditions, they are in danger of justifying whatever institutional status quo that exists in developing countries. Then what is the alternative?

One obvious alternative is for us to find out directly which of the “best practice” institutions are suitable for particular developing countries by transplanting them and seeing how they fare. However, as the failures of “structural adjustment” in many developing countries and of “transition” in many former Communist economies show, this usually does not work and can be very costly.

Another alternative is for the developing countries to wait for spontaneous institutional evolution. It may be argued that the best way to get the institutions that suit the local conditions is to let them evolve naturally. However, such spontaneous evolution may take a long time, and there is no guarantee that the outcome will be optimal, even from the national point of view.

These, then, point us to a third alternative that we pursue in this paper, which is to learn from history by looking at institutional development in the developed countries when they were “developing countries” themselves. In other words, the paper tries to draw lessons from the history, as opposed to the current state, of the developed countries.

2. The History of Institutional Development in the Developed Countries

In this section, we look at the evolution of the following institutions, which are widely regarded as essential components of a “good governance” structure, in the developed countries during earlier times, focusing on the period between the early 19th century and the early 20th century.

1.Democracy (section 2.1)The process of extending suffrage to unpropertied classes, women, and ethnic minorities was completed only during the late 20th century (votes to ethnic minorities in Australia and the USA in 1962 and 1965 respectively; votes to women in Switzerland in 1971). Secret balloting was introduced only in the early 20th century even in countries like France and Germany. Corrupt electoral practices (e.g., vote buying, electoral fraud, legislative corruption) lasted in most countries well into the 20th century.

2.Bureaucracy and judiciary (section 2.2)
Sales of offices, spoils system, and nepotism abounded in early bureaucracies. Modern professional bureaucracies first emerged in Prussia in the early 19th century, but much later in other countries. Britain got a modern bureaucracy got only in the mid-19th century. Until the end of the 19th century, less than half of the US federal bureaucrats were recruited through competitive processes. Judiciaries often lacked professionalism and independence and were prone to dispense “class justice”.

3.Property rights (section 2.3)
An attempt to chart the evolution of property rights regimes is not made in this section, since it involves an impossibly wide range of institutions. However, a historical examination of one tractable aspect of it, namely that of intellectual property rights institutions, suggests that property rights institutions in these countries fell acutely short of modern standards until well into the 20th century. Switzerland and the Netherlands did not have a patent law until the early 20th century, the US did not recognise foreign citizens’ copyrights until 1891, and there was a widespread violation of British trademark laws by the German firms in the late 19th century.

4.Corporate governance (section 2.4)
This section charts the evolution of some key institutions of corporate governance: generalised limited liability; modern bankruptcy law which facilitates “fresh starts” by the bankrupts; requirement for company audit, financial reporting, and information disclosure; competition law. Our study shows that, even in the most developed countries (the UK and the US), many key institutions of what is these days regarded as a “modern corporate governance” system emerged after, rather than before, their industrial development, that is, between the late 19th century and the mid-20th century.

5.Financial institutions (section 2.5)
This section examines the development of various private and public finance institutions: banking; central banking; securities regulation; public finance institutions (especially direct taxation). Modern financial systems with widespread and well-supervised banking, a central bank, and a well-regulated securities market did not come into being even in the most developed countries until the mid-20th century. The fiscal capacity of the state remained highly inadequate in most now-developed countries until the mid-20th century.

6.Welfare and labour institutions (section 2.6)
Social welfare institutions (e.g., industrial accident insurance, health insurance, state pension, unemployment insurance) did not emerge until the last few decades of the 19th century, although once introduced they diffused quite quickly. Effective labour institutions (e.g., regulations on child labour, working hours, workplace safety) did not emerge until around the same time even in the most advanced countries.

3.Institutional Development in Developing Countries Then and Now
In this section, we first of all depict 3 snapshot pictures of the level of institutional development in the developed countries in earlier times – 1820, 1875, and 1913 – to provide a panoramic view of what was a very lengthy and complicated process.

The following conclusions can be drawn when we compare the experiences of the developed countries in earlier times with the situations in the developing countries of today.

1.The developed countries in earlier times were institutionally less advanced compared to today’s developing countries at similar stages of development, not to speak of the even higher “global standards” that the latter countries are forced to conform to these days.

2.The developed countries in their earlier times grew much faster than the developing countries in recent times, despite the fact that the latter countries have institutions whose qualities are higher and have presumably improved following recent “structural adjustment” and “reform” programmes. This suggests that, contrary to what is assumed in the “good governance” discourse, many institutions follow, rather than lead, economic development.

3.It took the developed countries long time to develop institutions in their earlier days of development. The reasons behind such slow progress are varied and many, but institutions typically took decades, and sometimes generations, to develop. Thus seen, the currently popular demand that developing countries should adopt “global standard” institutions right away, or after very short transition periods, is unrealistic.

4. Implications
The current push for “good governance” by some donor governments and the IFIs is highly problematic in a number of ways. We argue that the following points have to be taken into account before the donor governments and the IFIs push this agenda further, if at all.

1.Our discussion suggests that many of the institutions that are currently being promoted as being “necessary” for development emerged after, and not before, economic development in the developed countries. Given that institutions are costly to establish and run, demanding the developing countries to adopt institutions that are not strictly necessary can have serious opportunity cost implications.

2.Even when we agree that certain institutions are “necessary”, we have to be careful in specifying their exact shapes. So, for example, we may agree that a “good” property rights regime is necessary for exchanges and investments to happen, but we still need to work out what this should in practice mean.

3.We should accept that institutional development takes a long time and be more “patient” with the process. It took the developed countries decades, if not centuries, to develop their institutions, with frequent setbacks and reversals in the process. Seen from this perspective, the 5-10 years’ transition periods currently given to the developing countries to bring their institutional standards up to the “global standard” are highly inadequate.

4.Fourth, given that the developing countries of today are already institutionally more advanced than the developed countries at comparable levels of development, asking these countries to install a large number of new “global standard” institutions and radically improve the quality of their existing institutions seems unreasonable, especially when such exercise can be “expensive” and often “unnecessary”.

At least two objections can be raised against the above arguments. First of all, one could argue that the “global standard” in institutions has risen over the last century or so, and therefore that the current developing countries should not consider the developed countries of 100, 150 years ago as their models. The second objection is that the developing countries should adopt the “best practice” institutions even if some of them may not be directly beneficial for them, because otherwise they will be shunned by international investors and suffer as a result.

We wholeheartedly agree with the first of the above two objections. Indeed, it will be absurd to do otherwise. Indeed, the developing countries should exploit the advantage of being late-comers to the maximum and try to achieve the highest level of institutional development possible. What we are wary about, however, is the view that institutions are simply matter of choice and therefore all countries should try to reach the (quite highly-set) “minimum global standard” right away or within minimal transition periods. We should not forget that it took the developed countries typically decades, if not centuries, in establishing new institution and another few decades to make them work properly.

The second objection is much more problematic for a number of reasons. First of all, it is not clear whether international investors do necessarily care so much about the institutions promoted by those who believe in the “good governance” agenda. The massive inflow of foreign investments into China is a good example. Second, while increased conformity to international standards in institutions may increase foreign investments, this benefit may be more than cancelled out by the financial and human resource costs of conforming to such standards. Third, even if certain “good” institutions get introduced under global pressure, they may not deliver the expected results, unless they can be effectively enforced. Fourth, contrary to the “follow the global norm or perish” argument, which assumes that the process of institutional evolution is beyond anyone’s control, the donor governments and the IFIs are not weathervanes blindly following the winds of international investor sentiments, but they can, and do, actively decide to a large extent which institutions they push for how strongly.

In conclusion, the currently dominant agenda for “governance reform” and “institutional development” needs a serious re-examination. In pushing for the “good governance” agenda, the donor governments and the IFIs need to:

(i) be more careful in identifying exactly which institutions are “necessary” for which developing countries
(ii) be more aware of the costs involved in setting up and running “high quality” institutions, especially when they may not be so “necessary”

(iii)be more realistic about the possible speed of institutional development in the developing countries and grant longer transition periods

(iv) have more humility and be more sensitive to the issue of historical justice in demanding high institutional standards from developing countries, given their own historical records.

Unless there is a complete change of perspective among the proponents of the “good governance” agenda in its present form, the push for “global standards” will at best remain highly ineffective in addressing the development failure of many developing countries and at worst be harmful for their development.